What Are 401(k) Loans and Should You Get One?

A 401(k) plan allows you to save for retirement on a tax-advantaged basis, with contributions that come straight out of your paychecks. If you need cash to consolidate debt, pay for home repairs, or cover other expenses, your employer may allow you to borrow from your plan. 

Taking out a 401(k) loan differs from getting other types of personal loans. There are pros—and cons—to borrowing from your retirement account. We’ve put together an ultimate guide to 401(k) personal loans to help you decide if one might be right for your situation. 

What is a 401(k) loan? 

A 401(k) loan is a loan that you take from your retirement savings. Essentially, you’re borrowing money that you (and your employer, if a matching contribution is offered) have contributed to your plan. Instead of paying money back to a lender, you pay it back to your retirement account. 

Taking a loan from retirement savings can be preferable to other types of personal loans if you’re able to secure a low interest rate or if you have poor credit. There is, however, a caveat. 

The money you borrow misses out on the power of compounding interest. That could leave you with a smaller nest egg once you’re ready to retire. 

How does a 401(k) loan work?

A 401(k) loan allows you to borrow from your retirement savings, but there are some rules to know. 

First, your plan has to allow loans. Not all 401(k) plans do and if yours doesn’t, you won’t be able to borrow. You can check with your plan sponsor or administrator to find out if 401(k) personal loans are allowed. 

Next, there are limits on what you can borrow. The IRS limits 401(k) loans to the lesser of:

• 50% of your vested balance, or
• $50,000

Your vested balance is the amount of your 401(k) that you own. You always own your original contributions but the percentage of employer-matching contributions you own depends on your plan’s vesting schedule. For example, there may be a two-to-six-year vesting period. 

Generally, you must repay a 401(k) loan within five years, with payments made at least quarterly. An automatic payroll deduction is the easiest way to repay a 401(k) loan. That can help you avoid paying late or defaulting, which can have significant tax consequences. 

The interest rate for a 401(k) loan is typically the prime rate plus one or two percentage points. Low rates are one of the most attractive features of 401(k) loans. Your plan may charge loan fees, including origination fees, or annual maintenance fees. 

It’s important to note, however, that you will pay double taxation on the 401(k) interest because you repay the loan with interest with after-tax money that you then get taxed on again when you withdraw from your 401(k) loan.

Pros and cons of taking a 401(k) loan

Be sure to consider the risks and benefits before proceeding with a loan.

Pros

• No credit check required

  You don’t need to worry about a credit check, which can be ideal if your credit score isn’t perfect.

• Lower interest rates than personal loans

  The interest rates are usually lower than what you’d find with most personal loans, so you can save money on interest.

• Interest paid goes back into your retirement account

  The interest you pay on the loan goes back into your own retirement savings, not to a bank or lender.

Cons

• Could slow down your retirement savings growth

  Taking out a loan means less money in your account, which might reduce how much your savings grow over time.

• Potential tax penalties if not repaid on time

  You might owe hefty tax penalties if you can’t pay it back on time.

• Double taxation

  Double taxation of 401(k) interest
  When you repay the loan, you pay back extra for interest using after-tax money, which then gets taxed again when you eventually withdraw from your 401(k).

• You may have to repay it faster if you leave your job

  If you leave your job (or lose it), you might have to repay the loan immediately, which could be a financial burden.

A 401(k) loan is a huge cash flow hit. The rule of thumb is $20 per month per $1,000 borrowed, so you will have a hefty reduction in your paycheck. Also, remember the risk if you lose your job or change employers.

Michael Menninger

CFP®

Alternatives to a 401(k) loan

If you’re considering borrowing from your 401(k), it’s worth looking at other options that suit your needs better. Here are a few alternatives:

Home equity loan 

A home equity loan lets you borrow against the value of your home. It usually comes with a fixed interest rate and a set repayment schedule. 

You might get a lower interest rate compared to other loans, and the interest may be tax-deductible. However, if you miss payments, you risk losing your home. Consider this option if you have significant home equity and are comfortable using it as collateral.

Home equity line of credit (HELOC)

A HELOC is like a credit card secured by your home’s value. It allows you to borrow as much or as little as you need up to a certain limit, with a variable interest rate. It’s a solid choice if you need flexibility in borrowing or aren’t sure how much you’ll need. Just remember that variable interest rates can go up over time, and, like a home equity loan, you could lose your home if you don’t keep up with payments. 

Compared to a 401(k) loan, a HELOC often offers more flexibility, but it requires you to have home equity.

Home equity sharing agreement  

A home equity investment, or home equity sharing agreement, is a unique arrangement where a company gives you cash in exchange for a share of your home’s future value. You won’t owe monthly payments, and it doesn’t affect your credit. 

However, it could mean giving up some of your home’s potential appreciation when you sell. This might be suitable if you want to tap into your home’s value without taking on new debt. But remember that it’s a relatively new option and can be complex.

Personal loan

A personal loan can provide quick cash without putting your home or retirement savings at risk. Just be aware that interest rates may be higher, especially if your credit score is less than stellar.

Credit card cash advance

Due to their high interest rates and fees, these should be a last resort. They’re only suitable for short-term needs where you can pay off the balance right away.

Borrow from family or friends 

A personal loan agreement with family or friends can offer low or no interest, but it’s essential to be clear about repayment terms to avoid straining relationships.

Exploring these alternatives can help you make a more informed decision that fits your financial situation without tapping into your retirement savings.

Ask the expert

Michael Menninger

CFP®

A 401(k) loan does not impact your credit, so it won’t impact your debt-to-income in the event you are seeking other types of loans.  If you don’t own a home, a home equity loan or HELOC isn’t an option. All things being equal, a 401(k) loan is a great option to pay off high interest rate credit card debt. I would much rather pay myself 8% interest than the bank’s 24%.

Who should consider a 401(k) loan? 

A 401(k) loan could be a better fit for some situations than others. Here’s a look at when you might consider borrowing from your workplace retirement plan. 

Consider a 401(k) loan if you…	Weigh 401(k) loan alternatives if you…
Have a borrowing need of $50,000 or less	Need to borrow more than $50,000
Have poor credit that limits your loan options	Have excellent credit
Plan to stay with your employer for 5+ years	Are likely to change jobs in <5 years

Minimal credit requirements can make a 401(k) loan attractive if you have poor credit or a thin credit file. Generally, 401(k) loans don’t require a credit check or affect your credit score. Other types of personal loans typically have a minimum credit score requirement you need to meet. 

If you have excellent credit, on the other hand, you might be able to find a low-rate personal loan option that doesn’t require you to drain your retirement savings. It’s worth comparing personal loan rates and lenders to see what’s available. 

Considering your credit profile, loan needs, and long-term career plans can help you decide if a 401(k) loan is a good option. 

Steps to take before you borrow from your 401(k)

If you’re interested in getting a 401(k) loan it’s important to consider the implications of doing so. Ask yourself these questions:

• How much money do you need to borrow?
• Can you continue contributing to your 401(k) while repaying the loan? (Some plans don’t allow this.)
• Does your budget allow you to repay the loan in the required five-year period? 
• Is a change of jobs on the horizon?
• How much growth will your 401(k) potentially miss out on? 
• Can you find personal loans that offer more favorable terms elsewhere? 

It may be worth talking to a financial advisor to understand how a 401(k) loan might impact you financially. Taking out a 401(k) loan can cost you years of compounding interest growth, which may leave you with less money than expected for retirement. 

Some 401(k) plans allow you to continue to pay the loan if you terminate employment. It is important to check this before applying for the loan.

Michael Menninger

CFP®

How to apply for a 401(k) loan 

How easy or difficult it is to apply for a 401(k) loan depends on the plan sponsor, as all plans are different. Here’s what the process typically involves. 

1. Check to see if your plan allows loans. A 401(k) plan is not required to offer loans and some don’t. You’ll first need to verify with your plan sponsor that a loan is an option.
2. Determine what you can borrow. You’ll need to know your 401(k) vested balance to figure out what you can borrow. This information should be available in your online account dashboard if you have one or on your latest statement. 
3. Review the terms. Before applying for any loan, it’s important to understand the interest rate you’ll pay, the fees, and the repayment schedule. Your employer or plan sponsor should be able to give you the details on how a 401(k) loan would work. 
4. Apply. Many 401(k) plans allow you to apply for a loan online. Remember that while credit scores don’t affect eligibility, your employer may still deny you for other reasons. 
5. Receive funds. Assuming you’re approved for a 401(k) loan, you’ll need to arrange to receive the funds. You may be able to get a direct deposit to your bank account, though some plans will cut a paper check instead. 

Once you have the money, you can use it however you like. The amount of time it takes from approval to loan funding can vary by plan. 

Tips to repay a 401(k) loan 

If you have a 401(k) loan, it may benefit you to repay it sooner rather than later for a few reasons. 

• A faster payoff reduces what you have to repay in interest and fees.
• You may be able to resume 401(k) contributions sooner if you had to temporarily halt them as a condition of the loan. 
• Paying the loan off means you’re earning interest on your savings instead of paying it. 

Whether you choose to accelerate your loan payoff or not, making the required payments on time is important. 

Paying late or not at all can put your 401(k) loan in default. If you leave your employer before a 401(k) loan is repaid, your plan may require payment in full at the time of your separation. In either case, non-payment can result in taxes and penalties. 

Tax implications and penalties 

A 401(k) loan is not taxed if certain conditions are met. The main requirement is that you repay the loan on time as agreed.

Again, you typically have five years to repay the loan unless you’re using the money to buy a home. Plans may allow up to 25 years to repay your loan in that instance. Here’s what happens if you don’t repay a 401(k) loan on time: 

• The outstanding balance is treated as a taxable distribution, meaning it’s taxed at your ordinary income tax rate.
• You could also be hit with a 10% early withdrawal penalty if you’re under 59½. Although, if you terminate employment after the year you attain age 55, you may not be subject to the 10% penalty.

A 401(k) loan doesn’t affect required minimum distributions (RMDs) from your plan. The IRS requires you to take minimum distributions from a 401(k) starting at age 73. Distributions are based on your life expectancy and plan balance. 

FAQ

Can I borrow more than one 401(k) loan at a time?

Yes, you can typically borrow more than one 401(k) loan at a time, but it depends on your plan’s specific rules. Many employers allow multiple loans, but they might limit the total amount you can borrow or the number of active loans you can have. 

Remember that all outstanding loans cannot exceed the IRS limit, which is the lesser of $50,000 or 50% of your vested account balance.

How does a 401(k) loan affect my credit score?

A 401(k) loan does not directly affect your credit score because it isn’t reported to credit bureaus. Unlike other types of loans, there is no credit check when you apply, and repayments are typically made through payroll deductions. 

However, if you fail to repay the loan on time or leave your job and can’t repay it, the outstanding balance may be treated as a taxable distribution, which could indirectly affect your financial health.

Can I still contribute to my 401(k) while repaying the loan?

Yes, in most cases, you can still contribute to your 401(k) while repaying the loan. However, some employers may have restrictions or limit the amount you can contribute.

It’s important to check with your plan administrator to understand any specific rules or restrictions your employer might have in place.

What happens if I lose my job?

If you lose your job, the outstanding balance of your 401(k) loan is typically due in full. You may have a short grace period, often 60 to 90 days, to repay the loan. 

If you can’t repay the full amount, the loan is treated as a distribution, which means you’ll owe income taxes on it, plus a 10% early withdrawal penalty if you are under age 59½. Some plans may offer more flexible repayment options, so check with your plan administrator.